NATURAL RESOURCES AND DEVELOPMENT

The role that natural resources play in stable economic development has recently attracted the attention of economists and politicians. An overwhelming majority of countries with a high average per capita gross domestic product (Western Europe, Japan) are not rich in natural resources. Africa, which after World War II was approximately at the same level of development as Southeast Asia, is today a region of extreme poverty (many Southeast Asian countries, by comparison, have slowly begun to catch up with the developed world). Just half a century ago it seemed that the Black Continent had very good prospects due to its natural wealth and relative proximity to European markets.

The abundance of natural resources, however, may serve as a negative factor for social and economic development. How can this be?

First, the presence of significant natural resources prompts the political and business elite to focus their efforts on controlling the natural resource rent, instead of seeking to increase labor productivity. When the elite is not interested in restructuring, modernizing and diversifying the economy, it loses an opportunity for implementing reforms.

Second, the inflow of funds generated by the sale of natural resources corrupts the ruling elite. On the one hand, the authorities are tempted to take a populist line: they can afford to experiment with economic policy and make rather extreme and irresponsible decisions; if the new policies have negative consequences, they can be relieved through large financial injections. On the other hand, the risk is high that corruption will inevitably grow as the authorities are engaged in the distribution of the natural resource rent.

Third, dependence on natural resources provokes the development of a lop-sided, often single-product, economy and, especially, single-product export. The so-called ‘Dutch disease’ impedes the development of non-export (in this case non-raw material) sectors of the economy: exports ensure the inflow of “cheap” foreign currency into the country, thus leading to an overstatement of the national currency’s exchange rate. This undermines the competitiveness of domestic producers oriented to the home market. The same process reduces investment activity, since the import of goods proves to be more profitable than the production of these same goods inside the country. Naturally, import substitution in this situation becomes practically impossible, and the economy becomes strongly dependent on fluctuations in export prices.

Fourth, the abundance of natural resources becomes a serious obstacle to political democratization. As mentioned above, a high natural resource rent impedes economic growth, that is, the achievement of an economic development level necessary for the formation of stable democratic institutions. This refers, above all, to countries where the bulk of the national budget is formed by revenues from the export of one kind of raw material (for example, oil). Control over this resource brings in enough revenues to meet the authorities’ needs and to ensure social stability, and allows the government to ignore other sources of income, thus leaving the national tax system undeveloped. The lack of the authorities’ need for significant tax revenues actually allows them to ignore the political demands of society and creates conditions for a peculiar “social contract:” “We do not levy taxes on you, and you do not demand political rights.” This is essentially how things stand in the absolute monarchies of the Persian Gulf.

Finally, some scholars argue there is a negative interrelation between the presence of natural resources and the authorities’ attention to the development of education. Sectors of the economy that are based on raw materials demand lower skills for the workforce. Thus, the domination of these sectors reduces the demand for educational services.

An additional danger arises when a country is suddenly inundated with natural resource revenues which are generated by a leap in their price. In the light of abundant revenues, the state begins to actively participate in various kinds of investment and social programs and comes out with ambitious projects for a foreign policy expansion. In a bid to make the best use of its opened opportunities, the state actively borrows additional funds from both inside the country and abroad. Consequently, despite an abundant inflow of money, the financial situation in the country greatly deteriorates.

Later, the country will find itself involved in a series of complex and ineffective economic and political projects, as its hopes for an abundance of “cheap” money prevent it from developing a serious cost-benefit analysis. Furthermore, overwhelmed by the tremendous inflow of funds, the state also gets more and more involved in reckless foreign-policy schemes.

On the other hand, the state’s social and economic structure is adapted to fit the new, favorable situation. The reliance on the abundance of “cheap” money makes the government forget about the effectiveness of other sectors – the deficiencies of domestic production, for example, can always be compensated for with imports. Domestic producers start degrading, which for some time does not worry the authorities who are lulled by the raw material-based economic growth.

But when the source of revenues suddenly disappears (due, for example, to a change in the market price of the natural resources), a full-scale crisis will appear which may hit the entire system.

Such problems have arisen in various countries over the last few decades. Many of these crises are obvious when we analyze the economic and political processes caused by fluctuations in oil prices following the 1973 oil crisis. Mexico, the Soviet Union, and Iran in the times of the shah’s rule provide the best examples.

At the turn of the 1970s, oil prices reached U.S. $90 per barrel (in terms of the present exchange rate), and it seemed that exporters had ensured an affluent future for themselves. Soviet leaders pursued an active oil-for-food policy, purchasing abroad consumer goods, foodstuffs, and equipment for expanding oil and gas production, while Mexico’s president José López Portillo declared proudly: “We must learn to administer abundance.”

Portillo’s policy of “administering abundance” provided for sharply increasing growth rates and strengthening the country’s economic independence through the development of the economy’s public sectors. The government launched various investment programs; growth rates increased from 3-4 percent (1975-1977) to 8-9 percent (1978-1981); the average annual increase in investment eventually reached 16 percent. At the same time, the national budget accumulated high deficits since the government pinned much hope on continued rates and therefore greatly ignored this parameter.

Mexico’s situation began to deteriorate with a decline in oil prices at the beginning of the 1980s: GDP began to demonstrate negative growth rates; the peso was devaluated by more than 40 percent; foreign debt increased from U.S. $40 billion in 1979 to $97 billion in 1985. Capital flight accelerated, and the gold and hard-currency reserves decreased to U.S. $1.8 billion. By the end of Portillo’s six-year presidential term, he was accused of wasting the oil revenues, concluding “extravagant” foreign-loan deals and inflating budget expenses. After his resignation, Portillo was forced to leave the country. When he died in early 2004, he was not even provided a state funeral, which was a departure from the usual practice.

The history of the Soviet Union in this regard is already familiar to most people. After wavering attempts to reform the economy in 1965-1972, the Soviet government completely abandoned these initiatives; it chose to ensure steady (albeit low) economic growth rates and social stability by stepping up energy exports. In the second half of the 1980s, the decline in oil prices and the growing budget deficit forced Mikhail Gorbachev to launch the so-called acceleration reform. This provided for resolute measures to reduce the country’s dependence on raw materials. These efforts to boost economic growth rates, however, threw the economic system off balance and triggered its collapse.

As yet another example, Iran’s regime initially gained from an oil price boom but then suffered a complete fiasco. Iran’s economy, as distinct from other countries, was hit by crisis during the most favorable situation on the world oil market. The main factor behind the destabilization was an accelerated modernization of the economy, which was conducted largely by decree and did not have deep roots in any sphere of economic and social life. As a result, Iran experienced a sharp increase in social tensions which culminated in the outbreak of the “Islamic revolution” in the late 1970s.

In all fairness, it must be admitted that some countries that are rich in natural resources have reached a very high level of economic development (for example, the United States, Canada and Norway). The reason is that some specific circumstances can neutralize the negative influence of the abundance of natural resources.

These circumstances include, above all, the nature of resources from the point of view of the possibility of monopolizing control over them. An abundance of natural resources that are “scattered” about a country and not available for monopolization by the state does not create a serious obstacle to economic development.

Norway provides a nice example. Its wellbeing was primarily built on the abundance of its fish resources, namely cod. Fishing, of course, is a far cry from hydrocarbon extraction: cod fishing does not require much investment, while the state can neither exercise rigid control over access to cod catching, nor accumulate this resource in its hands. Also, the location of cod is not always predictable. As a result, practically any Norwegian could engage in the fishing business, which laid the foundation for economic (and thus civil) freedom in relations with the authorities. As Finnish economist Pekka Sutela wrote, what is important is not whether or not a country is rich in natural resources, but whether these resources serve as a natural basis for the emergence of oligarchy and autocracy because of their high concentration, or as a natural basis for building democracy and equality as a result of their extensive occurrence.

One must add to this the extent of natural resource diversification. Natural variety and the absence of economic preferences for individual kinds of resources provide a basis for competition, the diversification of the economy, and the prevention of the formation of a single-product economy or single-product export. It is important to diversify control over resources, making it both state and non-state owned. Such tactics are an essential factor of steady economic development and, later, political democratization.

Second, a tremendous role is assigned to the political situation at the moment when the abundance of natural resources emerges. Occasionally the abundance of natural resources emerges in a country that is already experiencing a very high level of economic and political development. Under such conditions, governmental decision-making procedures for using natural resources are transparent. Furthermore, there exists a very low level of corruption, together with a diversified economy. Such countries include Britain and, especially, Norway, which unexpectedly came into possession of a great amount of hydrocarbon resources following the discovery of oil and gas fields in the North Sea. Even in this case, however, governmental policies continue to run the risk of sliding into populism. In the medium term – if we follow the trend of Norway’s experience of the last 20 years – the quality of economic policy will inevitably degrade under the pressure of various kinds of lobby groups.

Third, under conditions of abundant natural resources an economy can successfully develop in absolute monarchies. This is true since the national budget of those countries is actually identical to the budget of the ruling dynasty. Furthermore, there is concern about the future generations in monarchies because these are generally the rulers’ own heirs. The authorities in those countries are more capable of making long-term and effective decisions, including those intended to raise society’s general wellbeing. However, this type of regime is exceptionally rare in the contemporary world and their decisions are not always effective in the long term, as indicated by the record of the Gulf monarchies.

AMERICAN GOLD AND THE DOWNFALL OF THE SPANISH SUPERPOWER

It seems to be a general rule that when governments of different countries and different epochs encounter similar problems, they initiate similar steps and commit similar mistakes. This would apply to the situation when a particular country suddenly strikes rich natural resources – especially when this sudden gift is coupled with the country’s political ambitions.

After the unification of the kingdoms of Castile and Aragon in 1479, the possessions of the Spanish Crown rapidly expanded. By the 16th century, Spain was one of the strongest states in Europe and, therefore, in the entire world. By the middle of the century, the Spanish emperor’s rule extended to a large part of the Iberian Peninsula, the Netherlands, Sardinia, Sicily and the whole of Italy south of Rome. From there it traversed to the Central European dominions of the Habsburgs, and also to the newly discovered lands in America.

The country had a strong army (including Europe’s best infantry), navy, and extensive dynastic ties with the major royal houses of the Old World. There emerged prerequisites for the emergence of a new large empire, especially after King Charles I of Spain was crowned emperor of the Holy Roman Empire under the name of Charles V in 1519. The activities of Spanish monarchs had a pronounced messianic nature: the suppression of Islam and Protestantism, and the unification of the whole of Catholic Europe.

Economic factors also seemed to be on the side of the Spanish monarchy in its bid to become a real superpower. At a time when economic prosperity was based predominantly on agriculture, Spain held the leading positions in horticulture and sheep breeding. This, in turn, laid the foundation for the successful development of its textile industry. Add to this the high level of agriculture and several industries in the Spanish Netherlands, as well as the presence of mineral resources (iron, copper, tin and silver) in Spanish-controlled areas of Central Europe.

Yet the main source of the Spanish empire’s power was based on precious metals discovered in America. The new lands became the source of metal money – all the more valuable since silver had risen in price in Europe shortly before, causing a natural fall in the prices of other goods. By that time, new technological methods were invented for extracting silver, which considerably reduced the cost of its extraction in the New World. The money came into the possession of the Crown (that is, the national budget) and, to an even greater extent, into private hands, which contributed to the country’s enrichment and increased budget revenues (through taxes, revenues from coinage, and so on). Gold from America was expected to pave the way for the realization of Spain’s ambitious political goals. Quite possibly, the Spanish monarch viewed the new source of countless riches as God’s blessing for his Catholic mission.

The logic in the struggle for the title of superpower inevitably aggravated the foreign-policy situation and involved the Spanish Crown into a series of protracted wars. Active military operations, which continued for almost 150 years, required immense spending – the cost of war increased as the knight’s cavalry began to be replaced with firearms.

With the circulation of coin, silver and gold seemed to create the basis for the country’s reliable financing. The inflow of precious metals meant a sharp increase in the money supply, on the one hand, and the government’s budgetary resources, on the other. The abundant monetary flow enabled Spanish rulers to ignore the economic situation and therefore the need to update their tax and budgetary policies.

The economic policy of the Spanish government proved to be amazingly shortsighted (the same mistake would be repeatedly made later by other resource-rich countries). Spain did not have a long-term strategy to stimulate production, and the isolated measures enacted by the government were largely intended to ease social tensions and receive additional revenues. Certain elements of the Spanish Crown’s economic policy (i.e. attempts to regulate prices, the creation of monopolies on trade in staple goods and their production, high and unfair taxes and the retention of customs barriers inside the country) already looked old-fashioned in the 16th century.

To combat grain price hikes, for example, the government established price controls, which only brought about grain shortage. To cope with this problem, the government decided to stimulate grain import, which ruined domestic grain production and turned the country into a grain importer for centuries. The situation was much the same with its fabric production.

The Spanish tax system (with one of the highest tax rates in Europe) remained archaic. Although about 97 percent of all lands belonged to the aristocracy and the Church, direct taxes were levied on peasants, artisans and merchants. Some of the taxes were collected by the aristocracy, which then passed the money on to the Crown. Therefore the tax base proved very narrow, and the tax system ineffective in terms of budget revenues and remained purely fiscal, thus suppressing, rather than stimulating, economic development. There remained customs barriers between different parts of the empire (and even inside the Iberian Peninsula), which was motivated by fiscal considerations and the authorities’ devotion to tradition. Different currencies circulated in the country, making their conversion a painful process.

Thus, it turned out that the abundant inflow of precious metals was creating serious problems.

The first problem was that the need for money grew faster than the amount of funds received by the Crown from its overseas dominions. In spite of the abundance of monetary resources, the country faced a steady budget deficit, which had never happened before the accession of Charles I.

On the one hand, the vast silver and gold reserves allowed the Crown to borrow money in any amount, as it was confident of its ability to pay off any debts. On the other hand, creditors easily lent money on the security of future supplies of precious metals (and at usurious interest). Thus, Spain suffered from something similar to “moral hazard” – a condition described in contemporary literature – when an economic agent can afford a lackadaisical attitude to decisions made.

In the first half of the 1570s, Spain’s annual budget spending exceeded revenues by 50 percent, with huge sums of money used to repay old debts. For example, in 1575 alone, 36 million ducats – an amount equivalent to the country’s revenues over six years – were spent to pay off old debts. In 1577, the Crown’s revenues stood at 13 million ducats, whereas in 1582, the country’s accumulated debt amounted to 80 million ducats. Later, the national debt continued to increase, reaching an unprecedented sum of 180 million ducats by 1667.

The second problem was inflation. As it turned out, Spain fell into a trap: the abundance of currency metals provided the authorities with large monetary resources but, at the same time, reduced the per-unit purchasing power of the precious metals (see Fig. 1) which gave rise to inflation. This, in turn, reduced the Crown’s revenues.

Figure 1

Since inflation was at that time a little-known phenomenon in Western Europe, a large part of the treasury’s revenues was established in absolute values. In the second half of the 16th century, traditional budget revenues, fixed in absolute sums (see Fig. 2), began to decrease. For some time, the declining revenues were compensated for with American gold and silver, although, as it turned out later, the amount was insufficient for creating a steady financial basis for the expansionist policy of the Spanish authorities. Already in the second half of the 16th century, Spain’s budget, as a rule, ended up with a deficit (see Fig. 3).

Figure 2

Figure 3

Furthermore, since Spain was the first to be hit by the depreciation of a metal currency, the competitive ability of Spanish producers naturally decreased: the value of their goods in coinage was higher than the value of goods produced by other countries. Something similar to “Dutch disease” resulted, although its effect was not as significant as it would be within the present conditions of the global economy.

The third problem was that the empire’s economy and policy were adapted to meet the established situation with its currency revenues, which made Spain extremely vulnerable in two aspects. First, the Crown revealed its political and commercial weakness with regard to creditors who, knowing that the Crown could no longer survive without their loyalty, received an instrument for blackmailing. Second, the Crown was exposed to external shocks, that is, it became increasingly vulnerable to market fluctuations.

Spain received foreign loans at high interest rates from a financial cartel controlled by the Genoese, as well as from German, Flemish and Spanish bankers. By way of security, the Spanish Crown offered the creditors shares in silver supplies and individual tax items, and the bankers were given the right to serve the Crown’s financial transactions, including monopolies on international money transfers and currency exchanges. Considering that Spain’s lands were scattered throughout Europe, this function played a significant role not only in the economic sphere, but also in political and military respects. Since different parts of the empire had different currencies in circulation, the stability of money transfers was an imperative factor for maintaining political stability. A still more important factor was the implementation of financial transactions to pay war expenses; any incorrect move by the debtor prompted creditors to stop the transfer of money.

In the second half of the 1550s, the supply of American precious metals to Spain decreased, thus triggering the Crown’s first default in 1557, followed by another in 1560. (Those developments were preceded by an unprecedented political default: Charles V, apparently realizing that the mounting problems had a systemic nature, abdicated the throne in 1556 after forty years in power.)

Interestingly, between 1556-1560 the supply of precious metals to Spain decreased by more than half compared with the previous five-year period, yet their amount was proportionate with supplies from earlier periods (before the late 1540s). However, the preceding 15-20 years were marked by serious monetary and structural changes. On the one hand, inflation reduced the purchasing power of “American” money; on the other hand, the Crown’s dependence on new financial infusions increased as Spain was involved in more and more expansionist projects.

By the end of the 16th century, Spain became completely dependent on the state of affairs in the American mines. The country, which had formerly had a stable financial system, began to repeatedly default on its foreign debts: after 1557 and 1560, defaults occurred in 1575, 1596, 1607, 1627, 1647, 1653 and 1680. For some time (under Philip II), Spain continued to expand, and eventually conquered Portugal with its huge Eastern colonies (1581). Later, however, followed a series of military defeats (the crushing defeat of its Invincible Armada in 1588 came as one of the heaviest blows). The financial crisis was followed by a monetary one: not having enough budgetary resources, Philip III and Philip IV began to “spoil” the currency by reducing the gold and silver content of some coins. These measures, however, produced only short-term effects for the national budget and could not prevent a general degradation. The 17th century witnessed the steady economic decline of Spain, and it eventually turned into a second-rate country.

Despite mounting problems, the heirs of Charles V continued to abide by his policy: they focused their efforts on the achievement of imperial and messianic goals and ignored the need for creating favorable conditions for economic development. Spain lagged more and more behind other European countries, which took the leading positions (the Netherlands, England and France). Spain’s natural wealth (in this case tantamount to “cheap” money) played a trick on the country: having first created an illusion of political and economic invulnerability, it caused the Crown to change its needs to meet the new income level which led to a grave crisis. The crisis in Spain continued for four centuries.

Thus, the collapse of the Spanish Empire was a result of its over-inflated ambitions and ill-considered and ineffective economic and budgetary policies. The inflated political ambitions were partly provoked by the increasing inflow of “cheap” money, which prompted the Crown to intensify its efforts to consolidate and enlarge the empire.

World history knows many instances when countries conducted bitter and protracted wars without bringing things to financial or economic crises. These are, for example, the Netherlands of the 16th-17th centuries or Britain of the 18th century. Those countries did not have abundant natural wealth (thus cheap financial resources) and were ruled by more reliable governments which took into consideration the interests of production and trade.